In the midst of COVID-19, the domestic and global financial market outlooks are grim and the collective blow to the markets highlight the convoluted nature of their dependency and interconnectedness.
This notion applies to all financial markets, both domestic and globally: municipal debt markets, corporate debt, equities, commodities, etc. Furthermore, the notion that fixed-income markets often see a surge in capital influx during market downturns and recessions – because fixed income is generally considered a safer option than other instruments – may not be entirely true, given that investors are skeptical of the overall performance of both private and public sectors. This is also because both debt and equity markets are heavily reliant on consumer spending, which has come to a considerable halt.
In this article, we’ll take a closer look at whether the economic downturn will impact GO and revenue-backed municipal debt in a similar way, and we will also highlight key signs for investors to look out for within their municipal debt holdings in order to assess risk exposure.
As we take a closer look at both forms of debt and their structure, it’s more important to analyze how an economic downturn could impact revenue sources.
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GO Debt’s Risk Assessment in an Economic Downturn
For general obligation (GO) debt, a local government enters a “full faith and credit pledge” to levy unlimited – although, in some cases limited – ad-valorem property tax to meet its debt service obligations. The ad-valorem tax is based on the value of the property. For local governments, property tax revenues are often the main source of general funds revenues, which are used to maintain services like police, fire department, public works, etc. Under the “full faith and credit,” some government entities can raise these taxes to any amount necessary to meet their obligations, better known as the unlimited ad-valorem tax.
Now, let’s look at some of the key areas that should be part of your GO debt assessment.
- Sustainable Tax Base: The main basis for repaying general obligation debt is the strength and ability of the local economy – which includes the size, diversity of employers, and strong tax base – to meet its financial obligations. Since they are properties, their diverse ownerships and values are critical for sustainable tax-based income levels.
- Financial Preparedness: This may be the most crucial piece in the current COVID-19 environment for both local governments and government agencies. A local government’s organization style and financial preparedness determine its ability to withstand any potential downturns and sustainability. This preparedness isn’t limited to its reliance on general fund revenues, but it also takes into accounts the potential policies in place for an unforeseen event including reserve fund policy, liquid resources, and feasibility of long-range financial plans.
- Debt and Pension Obligations: Almost every local government has a crucial debt portfolio and retiree pension obligations to be met, which indirectly measures the financial leverage of a local government. What is alarming, as most of us know, is that several local governments in the U.S. are struggling to plan for unfunded liabilities in their pension funds.
Dont forget to check out our take here on understanding the comprehensive annual financial reports (CAFR) as reported by your local, state and other government entities.
Revenue Debt’s Risk Assessment in an Economic Downturn
In revenue-backed debt, as the name suggests, the municipal debt is secured by the revenues generated by municipal utilities providing various essential services. Some of the major services/utilities are water distribution, electricity distribution, gas distribution, wastewater disposal, storm water removal, and solid waste disposal. These essential services are provided to its users at a prescribed rate, which creates a stream of revenue for the respective enterprise. This stream of net revenues, after the payment of regular operations and maintenance expenses, is often pledged to secure any debt issuances.
Don’t forget to check the municipal debt screener here to select the debt of your choice.
Here are the few areas that investors should carefully examine before making their investment decisions:
- System Characteristics: This should be the first line of assessment to see how the financial downturn will impact a utility for consumers and also the payment priority. For example: understanding that a consumer is more likely to make their water payment before they pay their property tax bill. This parameter also measures the utility’s ability to fund its operations and capital needs in the future, based on the size and complexity of its operations, financial strength of its service base, and health of its capital assets.
- Financial Strength: This area is crucial in understanding a specific utility’s preparedness to handle any potential financial strains on its revenues. For example, due to the droughts in California, the state’s government introduced many measures for people to conserve water, which substantially decreased the water usage in California and, in turn, had a huge negative impact on local utility revenues.
- Management Track Record: This area refers to how the management team manages the utility rates charged to consumers, prepares and allocates the budget, and develops contingency planning to face adversaries in the future. These factors are crucial to determine the financial strength of any utility. Going back to the California example, the low water usage was compensated by raising the water rates by some local governments.
- Legal Provisions: This area refers to the debt structures and specific utility’s obligation to meet various debt covenants with its revenues; essentially, these debt covenants are the minimum standards the utility must legally meet, but they are often exceeded by the utility’s revenues.
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The Bottom Line
As the COVID-19 crisis unfolds, local governments are preparing to disclose, per municipal debt laws, the impacts to their revenue sources and any rating changes. The rating agencies are also following these impacts very closely and will make their assessments, accordingly, on downgrading the debt issuers and providing their outlooks for the remainder of the year.
Furthermore, issuers that rely heavily on non-tax revenues to fund their operations are more likely to be impacted. These issuers can be your transportation agencies, airports, and sporting arenas that rely heavily on their ticketing revenues from customers. In these times, investors should be watching their muni debt issuers very closely for new credit rating opinions and any changes that will adversely affect their investments.
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Disclaimer: The opinions and statements expressed in this article are for informational purposes only and are not intended to provide investment advice or guidance in any way and do not represent a solicitation to buy, sell or hold any of the securities mentioned. Opinions and statements expressed reflect only the view or judgement of the author(s) at the time of publication and are subject to change without notice. Information has been derived from sources deemed to be reliable, the reliability of which is not guaranteed. Readers are encouraged to obtain official statements and other disclosure documents on their own and/or to consult with their own investment professionals and advisers prior to making any investment decisions.